Mikhail Khodorkovsky couldn't make a long-arranged appointment with The Observer last week. Even Russia's richest man can't be interviewed when he's in a prison cell. But in Moscow we found no shortage of business people howling in protest at his incarceration.

Few other Russians are. Inhabitants of this still-poor country have no sympathy for billionaires and the arrest has boosted President Vladimir Putin's popularity ahead of forthcoming elections. As chief shareholder of Yukos, the oil giant sold for a song in the murky privatisations of the Nineties, Khodorkovsky is an easy target.

But the sudden escalation of Putin's feud with the tycoon - and the freezing of all Yukos shares belonging to him and his associates - is causing genuine alarm among investors. Fearful of the conservative 'grey cardinals' now advising Putin, many worry that the state has a secret plan to seize its former assets back. Could Russia's fast-expanding economy yet be re-Sovietised?

Absolutely not, say the president's men. Khodorkovsky's dramatic arrest on a Siberian airstrip last weekend reflects the seriousness of the charges against him, which include personal income tax evasion, overseeing corporate tax evasion, and embezzlement to the tune of $1 billion - all of which he denies.

The Kremlin insists that the asset-freeze imposed on Khodorkovsky is perfectly legal and shouldn't alarm other property owners; it is just a coincidence that he has also been financing Putin's political opponents.

'This is a decision taken by the courts,' says Aleksei Kudrin, the Minister of Finance. 'If the courts find Khodorkovsky not guilty, then he will be free to go back to work. His shares have been frozen, not confiscated, and Yukos continues to operate under its current management.'

Financial markets, though, are less than convinced. Russia's RTS1 index plummeted last week, and Yukos's market value has plunged. The move could hasten capital flight from the country, as the dozen or so 'oligarchs' who control half of Russia's wealth follow the lead of Chelsea's new owner Roman Abramovich and move their profits offshore.

Khodorkovsky's arrest could also deter foreign capital. The first casualty has been Russia's biggest corporate deal, a putative $25bn purchase of Yukos shares by ExxonMobil. Now that 44 per cent of Yukos's equity has been frozen by prosecutors, the deal is on indefinite hold.

'Nobody has any idea why this is happening,' says Bernie Sucher of Alfa Capital. 'This lack of clarity is a characteristic of Russia, and it's not acceptable.

'The images [of Khodorkovsky being arrested] are terrifying to business people in this country. We all know that we could be branded racketeers and taken down in the same way.'

Relative even to last year, though, the stock market is still riding high. Russia has always been a risky place to invest: that is why it earned only about £4bn of foreign direct investment last year, rather less than the Czech Republic. But those who do put money in - such as BP, which recently signed a record-breaking $6.75bn agreement with Russia's TNK - tend to be big enough to risk falling foul of corruption and cronyism.

They are lured - and will continue to be lured - by Russia's fabulous oil and gas reserves. Nor are corporations necessarily put off by strongman regimes: witness the surging investment in China.

There is an argument that Khodorkovsky is getting what he deserves. He has been branded a monopolist, a tax evader and a gangster, and although the allegations have never been proven, even his allies - such as opposition leader Boris Nemtsov - admit he is 'not an angel'. Why shouldn't such men be removed from the apex of Russia's commercial life?

Whatever the skeletons in his closet, Khodorkovsky has adopted international accounting standards in recent years, paid healthy dividends and brought respected foreign executives onto the board. Yukos is a better-run and more transparent company than many state-owned enterprises, including the gas monolith Gazprom and Transneft, the pipeline company.

Nemtsov - whose party has received donations from Khodorkovsky - told The Observer: 'The era of gangster capitalism is over; these days, oligarchs want stability too. Khodorkovsky is not a danger to people in the street, and unlike other oligarchs, he doesn't want to leave Russia. His arrest is political and I fear we are in transition from democracy to dictatorship.'

Last week Sir John Egan, the Inchcape chairman and CBI president, attended a lunch in Moscow hosted by the Russian Economic Forum. 'Khodorkovsky's arrest has brought an element of uncertainty to the marketplace,' he said. 'But my personal impression is that this is more personal than economic, and I expect to see economic reforms continue.'

The remark drew a mild rebuke from Igor Yurgens, his dining companion and Russian opposite number: 'We would prefer this to be an economic confrontation than a political one.'

Four hours later, it was announced that Khodorkovsky's Yukos assets had been frozen, and there was a fresh bout of trembling among Moscow's wealthy elite. All are asking whether the government is using a court case to renationalise Yukos. Thanks to the peculiarities of Russian law, if Khodorkovsky and his fellow accused are found to have acted in concert with criminal intent, they are guilty of 'organised crime'; and that means the state has the right to seize their assets.

'If the government tries that trick, then we're in a whole new ball game. I believe that Western capital would bail out of Russia immediately,' says a high-profile American banker based in Russia. Privately, British diplomats are also concerned that the rule of law is being subordinated to the whims of a remote and inscrutable president.

Until now, Putin has been seen as probably Russia's most commercially minded leader. Measures enacted by his government in recent years - a 13 per cent flat rate of income tax, corporate tax cuts, simplification of the labour laws - have been credited with stemming the flow of capital flight.

Buoyed by a devalued rouble and the soaring oil price, Russia has recovered from the debt crisis of 1998 to enjoy economic growth of 6 per cent a year. Only a fortnight ago, the country was given its first investment-grade rating by Moody's. And next year, private pension schemes are to be introduced for ordinary citizens.

Many kremlinologists believe that Putin's commitment to market economics is more pragmatic than ideological. The growing influence of Viktor Ivanov, Igor Sechin and other advisers who, like Putin, rose to authority via the KGB, is also causing concern. When Alexander Voloshin, Putin's business-friendly chief of staff, stood down last week, it was taken as another sign that these 'siloviki' or 'hawks' are in the ascendant.

They are, as far as anyone can tell, bitterly hostile to the oligarchs, believing them to be the undeserving beneficiaries of resources that belong to the nation. Reclaiming Yukos, it is said, is at the top of their wish-list. It is even rumoured that Khodorkovsky's arrest was carried out at their behest and without Putin's prior knowledge.

The Khodorkovsky 'crisis' comes as the country stands at a kind of crossroads. Russia is interested in joining the World Trade Organisation, but much of its economy remains unliberalised. State-owned Sberbank remains Russia's biggest lender to industry and its only significant retail bank; and Gazprom is largely out of bounds for foreign investors, despite being the world's biggest gas company.

Those few shares that are publicly available nearly always derive from the oil industry. Russian wells now pump out 9 million barrels a day and represent a quarter of the national economy. The country is dangerously overdependent on one sector, and if world oil prices were to collapse, economic growth, inward investment and Putin's budget surpluses would go into reverse.

This, rather than the president's little local difficulty with Khodorkovsky, is what really exercises the minds of Russia's economic star-gazers. On the other hand, the two issues could be connected. What is happening to the Yukos chief executive may reflect Putin's determination to take a firmer grip on Russia's oil economy.

Besides, Khodorkovsky's patronage of opposition politicians was such that he would soon have 200 MPs in his pocket, some commentators said. Putin has tough decisions ahead, and could do without billionaires getting in his way. What foreign investors and Russia's rich will make of his methods remains to be seen.

How Yeltsin enriched the oligarchs

The first half of the 1990s was bonanza time for Russian entrepreneurs as the country emerged from the communist era; and they found a willing accomplice in the government of Boris Yeltsin.

Yeltsin's rush to liberalise the Russian economy - seen as vital to political modernisation - led to a sell-off of state assets on an unprecedented scale. By spreading assets previously held by the state among the people, Yeltsin hoped to create a vast 'popular capitalism' to fit in with Russia's collectivist tradition. In fact, he got just the opposite.

The first mass sell-off of industrial, agricultural, commercial and service sectors was sparked by a 1992 decree which gave each Russian adult vouchers to the value 10,000 roubles to buy shares in the firms which employed them. 'What we need is millions of property owners, not merely a handful of millionaires,' said Yeltsin.

Shrewd entrepreneurs quickly realised that the assets being sold were massively undervalued. They bought the entitling vouchers from the workers and gained control of the state's most prestigious industries. For example, Gazprom, the biggest energy company in Russia, was valued at only $250 million on privatisation, but in 1997 had a stock market value of $40 billion.

The oligarchs cemented their control and their wealth during the 1996 election. Yeltsin needed campaign funds, and effectively hocked state interests in the mining industries to the oligarchs in exchange for loans. When the state failed to repay the oligarchs ended up with control of Russia's vast natural resources - and the billions they could command on world markets.